When and How to Incorporate
If you've been in business for a while as a sole proprietor, you may be wondering whether it would be a good idea to incorporate. We can help you make that decision with information about why a business owner would want to incorporate, how a corporation is structured, and how corporations are taxed.
Key Takeaways
- Usually, you can incorporate by filing Articles of Incorporation in the state where you want your business to be headquartered. Most states will send you a Certificate of Incorporation.
- When you incorporate, you’ll need to appoint directors, draw up bylaws, and issue stock to everyone who is an owner of the corporation.
- A C corporation files a business tax return and pays tax on its corporate profits.
- You’ll pay tax only on any compensation or dividends you receive from the C-corp.
Reasons for incorporating
Picture this: You started a small landscaping business a few years ago as a sole proprietorship with three employees. Demand was so great for your services that you kept hiring more people and taking on debt to purchase more equipment, and the number of customers has soared. But lately you've started to wonder: What happens if business slows and you can't pay back all the debt? What if a disgruntled employee or unhappy customer sues you? As a sole proprietor you're typically personally liable for any bad debts and legal judgments against your business, meaning that your home and other personal assets could be at risk.
When you incorporate, you're creating a completely separate legal entity, one that can shoulder the liability burden you had been carrying yourself (or if you are a partnership, the burden you and the other partners were carrying).
Forming a corporation also allows you to:
- reward and retain key staff by giving workers a piece of the business
- attract equity investors rather than only relying on debt financing
- shift tax liability away from you to the corporate entity
But you'll have to weigh some disadvantages as well:
- It usually takes more time and money to incorporate than to form other types of businesses.
- Corporations typically are subject to more regulation at both the federal and state level, and the tax rules can be more complicated.
- The management structure of a corporation is usually more rigid, sometimes giving you, as the owner, less flexibility to run things as you want.
Corporate structure
Typically, a corporation has a three-tiered structure, which consists of:
- Shareholders: As company owners, shareholders are the foundation of the corporation. They often have the power to select and remove directors, amend bylaws, approve the sale of assets and dissolve the corporation. You don't necessarily have to have a lot of shareholders. In fact, most states permit one person to hold 100% of the corporation's stock.
- Directors: They act on behalf of the stockholders, managing the company, making major decisions about the firm's direction and electing company officers. Most states allow corporations to have a single director, but some require a minimum of three.
- Officers: In most states, corporations must have at least a president, secretary and treasurer to handle day-to-day running of the business, but many states also allow one person to hold all three positions.
TurboTax Tip:
If you incorporate your business, you no longer have to pay self-employment tax on all of your business income. The Social Security and Medicare taxes are typically only due on salary and bonuses paid to you by the corporation rather than the entire profit of the company.
Steps to becoming a corporation
To get your corporation started, you'll need to draw up Articles of Incorporation in the state where you want your business to be headquartered. The articles declare basic facts about the company, including its name, purpose and the number of shares authorized to issue to shareholders. You file this document with the appropriate state office (usually the Secretary of State or Department of Commerce) and typically pay a filing fee, which can be as much as several hundred dollars. You may want to hire an attorney to handle the process. You will typically receive a Certificate of Incorporation after the paperwork is complete.
With your Certificate in hand, you can take the next steps, including appointing directors and holding your first directors' meeting. You'll need to draw up bylaws, which detail the rights of the shareholders, directors and officers. You also need to issue company stock. It doesn't have to be widely held, but typically needs to be distributed to everyone who is an owner of the corporation.
Tax issues for corporations
Once you have incorporated, you'll probably notice a big difference in how your company is treated for tax purposes. You'll no longer file Schedule C with your Form 1040 tax return as you did as a sole proprietor. Instead, the corporation files a business tax return, Form 1120 for a C corporation and pays tax on its corporate profits. S corporations file Form 1120S and do not typically pay tax at the corporate level. S corporation profits and losses are passed along to the shareholders who receive a Schedule K-1 from the corporation that shows what information for shareholders to include on their personal tax returns.
Many owners of new, small corporations may get a pleasant surprise at tax time. That's because sole proprietors can't deduct any salaries they pay themselves, but after incorporating they typically become employees, and their compensation can be written off by the corporate entity. Once those and other deductions are taken, there may be little corporate profit left to tax. But shareholders typically do have to pay tax as individuals on any compensation, dividends distributed by a C-corp, or profits passed through by an S-corp.
A valuable tax break
Even better news: Business owners typically don't have to pay the self-employment tax on their entire profit after they incorporate. As a sole proprietor, you pay self-employment tax on the entire business profit, which in 2023 is 15.3% on the first $160,200 of your net earnings from self-employment. For earnings above that, you pay Medicare tax of 2.9% but not any more Social Security tax. As an employee of your corporation, the firm withholds half of these taxes from your paychecks and pays the other half for you. The Social Security and Medicare taxes are typically only due on salary and bonuses paid to you. Any remaining corporate income is typically not subject to these payroll taxes.
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